Role of Gold in a Long Term Portfolio
Here is what you need to know
- Gold is a controversial topic and there is a lot of misconceptions about Gold and facts that may surprise you
- You may be surprised that owing Gold is Risky – it can be a very volatile asset on its own
- On top of that, Gold is prone to short term sell-offs during a crisis at exactly the same time as Stocks – this is due to market-wide liquidations
- However, Gold works really well within a diversified Portfolio and offers good diversification with no correlation to Stocks in the long term
- Gold reacts well within longer periods when Stocks under-perform and will hedge your portfolio
- Don’t get emotional about Gold and over-concentrate in Gold like some doomsayers/goldbugs would encourage you to do but treat it like an insurance for extreme risks
- While sub-optimal compared to Bonds as safe haven (outside of some unlikely but high impact events) low Yields may make it reasonable to consider Gold as a partial alternative. Here is why.
The Ultimate Currency
A Bloomberg Terminal used by Bankers and colored asset classes on its keyboard
- Gold is a currency and a commodity (to a marginal degree)
- It’s a controversial asset – some Finance people I know avoid it while a lot of traders allocate a substantial amount of their savings to Gold. It can get emotional. People in banking are pretty rational, unless you talk to them about Football or Gold
- For the Finance community it’s a currency, the ultimate currency. In fact Financial Analysts using a Bloomberg terminal must enter ‘Currency’ after typing the Gold ticker to get information about it or its latest price
- Aswath Damodaran, one of the most respected academic asset valuation researchers summarized it follows: “Gold’s value has more to do with its longstanding function as a store of value, especially during crises or when you lose faith in paper currencies, it is more currency than commodity”
- Gold is also a commodity as technology companies use it in industrial processes – but the demand is marginal. According to the World Gold Council’s data, it accounts only for about 17.5 percent of the total demand for gold
Gold's historical value comes from difficulty of acquisition
Of all the literature related to Gold, Joe Weisenthal, from Bloomberg has in my opinion one of the best ways of summarizing historical importance of Gold. Here is his take.
One of the striking things about gold is just how incredibly hard it is to attain (and hold onto once you have it) and the different things you have to master to get gold
To get Gold you:
- Have to be good at warfare
- Be able to marshall an extensive human workforce to mine it
- Mastery of global supply and logistics routes
- Be able to command guards who will watch your gold, and not steal it
- Have the technical know-how to get gold out of the ground, which is expensive and
When you have gold you’re communicating all the different things you’re capable of (mastering supply routes, commanding an army, scientific endeavor, marshalling labor, etc.)
Gold, then, is a very specific proof of work. If you can get gold, you’ve proven that you have the ability to run a state or some state-like entity
As with all currencies, Gold has no yield on its own
- Unlike bonds, gold does not pay interest or dividends
- This perceived lack of yield often deters some investors
- It also does not have credit risk
- You also need to account for storage costs
The Bad - Gold is Risky
How volatile is Gold?
- Despite popular safe haven belief Gold is inherently risky – especially for people that don’t diversify enough and have a high concentration of their wealth in Gold
- On its own, Gold is a volatile asset – in fact, if held for 5 years you could still have faced up to a 40% loss on several occasions over the past 3 decades
- The below graph illustrates Profit / Loss for $1000 invested in Gold and held for 5 years
If the stock market crashes will Gold go up?
Not necessairly in the short term. You can see that there is a short term sell-off period for Gold in the middle of the 2008 Crisis (circled in yellow below) – despite its safe haven status liquidations of assets have short term impact on Gold.
However, Gold acted as a great long term Equity hedge during the GFC. It has returned up to 280% in 2010/2011 if bought 5 years earlier and held for that same 5 year period.
In the long term, more often than not a crisis comes with at least one of 5 the risk factors (appendix), acting as positive catalyst for Gold prices.
It is frequently deflation, expectations of high inflation and/or a weaker Dollar.
Net Profit & Loss at the moment of sale on $1000 invested in Gold 5 Years earlier (5 Year Holding Period)
The Ugly - Gold can underperform for decades
Is Gold a good investment for the Long Term?
- In short, no. In fact, I think it’s a stretch to call it an Investment, similar to other currencies. I would rather call it a diversifier.
- Price moves are of course even more extreme if you invested at the top of the market. It’s a great way of looking of what losses you can sustain, if looking at Gold in isloation – even in the long run. Below is the graph representing scenarios where you would have invested at (Gold) market peaks.
- The below graph gives you a long term perspective on how Gold can have decade(s) long under-performance, starting in 1980s when Gold peaked
- It subsequently recovered from 2000 onwards and peaked again in 2011
- Recently, Gold has rallied since mid-2018
Lost decade(s) - Net Profit & Loss on $1000 invested in Gold from its previous market peak
The Good - Gold in a Portfolio works well
Does Gold have a place in a Long Term Portfolio?
- Gold provides good diversification benefits – only inferior to Treasuries but if Yields are low, holding Gold (or Bitcoin) has low opportunity costs
- While Gold is volatile on its own, within a portfolio with Equities and Bonds, a small allocation may improve the risk/return profile of your portfolio
- There were/will be scenarios where other asset classes will underperform and you may then use sale proceeds from Gold to purchase other cheaper assets that generate yields/dividends
- Gold may help you to rebalance your portfolio in a certain crisis scenarios but this may not be as immediate as Bonds due to market-wide asset liquidations
- Read what diversification means and how to read the below table
Gold Portfolio Diversification Benefits 1999-2019
Here is a guide on how to select assets for your portfolio. Simplify your portfolio by following these allocation strategies to improve performance and time you need to dedicate to portfolio management. Understand how to clean up your portfolio from asset classes you don’t need.
In combination with Bonds
Can Gold replace Bonds in a Portfolio?
Net Return on $1,000 from a 70% International Equity Portfolio and 30% Gold or Bonds over 5 years at time of sale (5 Year Holding Period)
- The above chart represents a return in USD (before fees) from holding a 70% Equity 30% Bonds or Gold Portfolio over 5 years time at the time of selling the investments (assumed 5 year holding period)
- Bonds provided better overall returns up until the Global Financial Crisis but since then Gold resulted in higher Portfolio returns
- Remember, that Gold is much more volatile (15% Risk as measured by standard deviation vs. 3.5% for Bonds) and your overall portfolio risk in the example above increased as well
- It confirms that you should have both Bonds and Gold in your portfolio since the protection benefits do not kick in at the same time depending on type of market events
But why is Gold so volatile?
You don’t have to understand the technical details to be able to benefit from Gold – in fact diversification is all that matters.
However, it’s good to have an understanding of what really makes it a different asset and when you may need it (of course, I assume that no one can get the timing right).
Here is why it’s not as safe as often perceived.
But also why owning it makes sense.
Appendix - THE 5 Gold Price Drivers
#1 Opportunity Cost
What is opportunity cost of holding Gold?
Low Real Interest rates is the elephant in the room when it comes to explaining what drives most of Gold price
Investors are turning to gold because of one simple fact – deeply negative Real Yields (Treasury Bond Yields after accounting for Inflation)
The more Treasury Bonds are generating negative real returns the more attractive Gold becomes. After all, buying a bond that is guaranteed to lose you money is a tough sell
Gold price has moved in line with Real Interest Rates for more than a decade
According to a BlackRock analysis Real Yields explain around 30% of the price of Gold – the strongest factor, by far. But it is not true in all environments when other price drivers take over
We could break it also down into three periods:
- 1982-1999 (High Real Yields)
- 2000-2008 (Decreasing Real Yields) and
- 2009-2019 (Low Real Yields)
In the first two periods when Bonds offered positive / high real returns there was little or low relationship between Gold and Real Yields (it may be the case again if Real Rates go up one day)
That said, in the current low yield environment there is clearly a strong correlation between rates and Gold prices
Gold follows Real Yields closely
BlackRock estimates that a rule of thumb is that every 0.10% drop in Real Yields coincides with about a 1.25% increase in Gold Prices. Real Rates are already low hence any potential coming from Rates is by definition limited
How do I track opportunity cost of holding Gold?
You can easily track daily Real Rates from US Department of Treasury website or the FED – the lower the rates the lower the opportunity cost of holding Gold (and higher its price)
#2 Dollar strenght
Why does Dollar strenght impact Gold Price?
This reason is mechanical – Gold is quoted in US Dollars
- Thus, historically Gold outperformance is strongest when the Dollar is down. It’s valid over long periods of time. During Coronavirus both the Dollar and Gold were perceived as Safe Havens and a stronger Dollar didn’t have a major impact on Gold. This may revert as the Economy stabilizes.
- Monetary Inflation increases prices of all assets including Stocks and Gold on the back of unprecedented stimulus by the FED which will make the USD relatively weaker (Price inflation of Real Assets since these are quoted in USD)
How do I track Dollar strenght?
You can easily track USD Strenght vs major currencies (predominately the Euro) by following the Dollar Index (DXY).
Essentially, this tracks how strong is the USD versus a basket of other currencies. A stronger Dollar vis-a-vis other currencies may mechanically weaken Gold
#3 Macro Shocks
As you may have observed during the COVID-19 Crisis, each Jobless claim on Thursday came with a surge in Gold Prices
Other Economic indicators have similar effect. Gold may ultimately react negatively to a more positive outlook.
Any potential geopolitical or Economic Conflict (e.g. Escalation of Trade War with China) may also impact Gold and provide a hedge to your Equity portfolio.
There is also a possibility of other Tail Risks combined with current situation (remember how the Oil Price War escalated quickly). We just don’t know but Gold is an Insurance in these instances
#4 Very High Inflation
How high must the inflation rise to benefit Gold?
Gold performs well is sub 1% or above 3% Inflation
In terms of inflation regimes, average Gold returns have generally been most significant during extremely low (less than 1%) or high (greater than 3%) inflation.
Is it a good time to buy Gold with inflation between 1% an 3%? In those episodes gold returns were lackluster (pun intended)
When the 60 Stocks / 40 Bonds Portfolio doesn't quite work
- The real price of imported oil in the U.S. increased 6-fold in the 1970s, leading to runaway inflation and stagnant economic growth.
- Initially, stock-heavy portfolios were hit the hardest, declining up to 50% within 18 months
- Later, as inflation accelerated, bond-heavy portfolios suffered as well, declining up to 40% by 1981 (inflation adjusted chart below)
Note that I used a separate axis (right) for Gold since it is so much more volatile compared to Bonds and Stocks (acts like an option aka insurance)
Oil and Inflation Shocks of the 1970s
In essence, we would need to see a significant jump in inflation for Gold to benefit materially.
This has also not been the case post the GFC – when gold has been frustrating to trade. The prediction that drove the post-crisis rally — that quantitative easing would lead to high inflation — did not play out. Gold tumbled to below $1,100 by late 2015. Bears can also point to the two-decade slump that followed a high in 1980.
How do I track Inflation Expectations?
One of ways of tracking medium term inflation is using FED’s 5 year breakeven inflation rate
This graph will show you the expected annualized inflation over the next 5 years.
#5 Commodity, Retail and Central Bank Demand
Gold has a traditional supply / demand market as commodity (technology) in Jewellery or protective asset demand from Retail / Central Banks. Demand for Jewellery may currently be the weakest aspect of current Gold appeal. This aspect is largerly driven by Emerging Countries and more specifically Asia (50% of overall Gold demand comes from China and India)
Despite initial signalling Emerging Countries’ Banks are likely to continue the long term trend for central banks to be net buyers of Gold post GFC
How do I track World Gold Demand?
One of ways of tracking demand is through the World Gold Council website and its quarterly reports
Research the appropriate ETFs based on your needs
- If you decide to invest in Gold you may consider physical gold or Gold ETF
- Only consider Gold in a diversified Portfolio (Read how can Gold fit in a Long Term Portfolio))
- I have done some research for you and the Largest Funds are listed below
- An investment in gold is easily done with listed products, like ETFs or ETCs (How are they different?) These investment products track the spot gold price closely, after taking management fees into account
- Performance vary by currency (Gold is quoted in USD and then converged into local Fund Currency)
- I have not included leveraged Funds (understand their risks)
Gold ETFs by Exchange Listing
- Check the size of the fund and liquidity – it is usually preferable to stick to the larger vehicles that are more liquid (why liquidity matters)
- Low fees are the most cost-effective feature of an ETF – make sure you select a low fee vehicle. Check the expense ratios from our dashboard or the ETFdb website and plug them here. You can compare the effect of fees on your overall returns using my ETF fee calculator. You may be surprised of the high impact
- How is the purchase or sale of an ETF going to affect your tax return? While U.S. based ETFs have many tax advantages, a foreign ETF may not be so tax-friendly and therefore not cost-effective. Tax implications vary from region to region
- Verify any commissions and fees charged by your broker
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